European Sovereign Debt Downgrades

Not terribly surprising news on Friday evening: S&P downgraded the credit rating of 9 European countries.

This is a prediction of increased future risk, but it is based on negative behavior in the recent past. It’s analogous to admitting your probably going to throw more interceptions because you’ve gotten down by a couple of touchdowns and need to adjust your gameplan to pass the ball more.

I’ll return to the news itself further down, but for right now there are a bunch of details and definitions you’re not likely to pick up all in one place, so here goes. Note that this post is important, but that you shouldn’t judge the importance of my posts by their length. This one just has a lot of details.

The typical exchange in a loan is to give up something of (known present) value today in exchange for a stream of future payments with a larger present value. The big risk in doing this is default: that the borrower will stop paying before the stream of payments is finished.

As a lender, what you’d like to to know is what the chance of that default is before it happens. Estimating such a thing before it has happened is called ex ante. Going back and looking at past data to figure out how often defaults occur is called ex post. Using the football analogy, a coach chooses plays for which the quarterback has  a low ex ante  probability of throwing an interception, while critics of teams are looking at ex post results to determine which passes should have been thrown. S&P’s ratings are an ex ante measure of default risk.

Ratings can be done by anyone; the question is whether anyone would pay attention to them. Many ratings are done internationally, but in America there are three firms (two big and one small) that do almost all the ratings. Because America is the largest investment market, our rating agencies get a lot more attention than those of other countries. The two big agencies are Standard and Poor’s (aka S&P) and Moody’s, while Fitch is the smaller one.

In America, the ratings agencies are private firms. But, there isn’t really free entry, since the Federal government stipulates that most investors need to be able to show that their investment was rated by one of those three firms. This is a good point to recall that micro theory suggests that 1) limits on free entry lead to products that are sold at a price above marginal cost, and 2) quality of that product is likely to decline through time because there isn’t enough incentive to keep average costs low if you’re making incremental profit on each sale. This is known as the “lazy monopolist” problem, but it applies anywhere incremental margins are positive.

The quality of the product sold by a ratings agency is assessed by examining whether the ratings made ex ante match up with the default rates observed ex post. In the long-run, these will have to match up or the rating agency’s business will go to one of the other raters. But, in the short-run, there can be substantial deviations between the two, which was a major source of criticism in the wake of the breakdown of the market for CDO’s (i.e., bundled mortgages) in the recent financial crisis.

The rating agencies all have different scales for their ratings. Roughly, they follow a few simple rules. First, they’re like letter grades: A is better than B. Second, plus is better than minus. Third, as in baseball leagues, more letters is better than fewer (e.i., AAA beats AA).

To allow some comparison between firms, ratings are described as “notches”. For example, to go down two notches is to go down two ratings in a particular agency’s scale.

Issues of debt are not always required to get a rating from more than one firm, but they often do. A problem in the acute part of the financial crisis in 2008-9 was evidence that the agencies were using each other’s ratings as the basis for their own rating (as a cost saving measure) rather than doing their own due diligence.

A debt issue is called “junk” if it earns a rating that is very low on a firm’s scale. It does not indicate that default is probable, only that it is more likely.

Ratings agencies are not in the business of surprising the borrowers they are rating, or their potential lenders. Borrowers are informed frequently of how their actions are likely to affect their ratings, and when a revision is likely to occur. In addition, when things start to point in one direction, they usually make a press release indicating to investors that a rating change is more likely although not yet probable.

Sovereign debt is the name given to debt issued by the central government of a country. Historically, this is a political distinction: the central government has the ultimate command over the resources used to repay the debt. For trivia, we call it sovereign debt because it used to be debt that was personally owed by the absolute monarch of a country.

We need a new term for what is going on in Europe. Economists like to note that the economics of a situation trumps the politics (even if politicians don’t like to admit this). In practice, when a government is unable or unwilling to marshal the resources to repay debt, it prints currency (which devalues it). The countries of the Euro-zone have given up that ability when they deprecated their local currency in favor of the Euro. But they are acting as if nothing has changed. Journalists and politicians need to stop calling issues within the Euro-zone sovereign debt; “pseudo-sovereign debt” would be better.

Additionally, European governments have spotted a bad thing, and decided it would be cool to copy it. A big problem in the corporate and government world is the creation of financial entities that are off the books. In short, someone has a problem, so they create a second entity, move all the problems over there, shovel some money at it, and then claim they are clean. It’s not a good idea, but it’s very human: parents do this all the time when they stop supporting kids with substance abuse problems. Anyway, European countries have created something called the EFSF (European Financial Stability Facility): the countries that are doing well pour money in, and the EFSF helps manage a turnaround in problem countries. On paper this sounds good, and it avoids national chauvinism. The problem is, can it really have any less chance of default itself than some chance of default that is representative of where its funds are coming from? This was the problem with CDOs (bundled mortgage) in the recent financial crisis: they would bundle two B’s together and call it an A because now it was diversified. Maybe so, but clearly not enough. We have the same problem in Europe now: the EFSF has a separate and better rating than most of its contributors. It’s not an absolute guarantee of a problem, but it sure looks like more smoke and mirrors.

Now that you have some tools, let’s go look at the news.

1) Big financial news is often released early on Friday evening. This is after markets in America have closed for the day, and going into the weekend for global markets. It’s also after the evening news.

2) S&P had sent out a warning about a month ago:

In December, S&P placed the ratings of 15 euro zone countries on credit watch negative — including those of top-rated Germany and France, the region's two biggest economies — and said "systemic stresses" were building up as credit conditions tighten in the 17-nation bloc.

3) Here are the actual moves:

S&P lowered its long-term rating on Cyprus, Italy, Portugal and Spain by two notches, and cut its rating on Austria, France, Malta, Slovakia and Slovenia by one notch.

…

The credit-rating agency affirmed the current long-term ratings for Belgium, Estonia, Finland, Germany, Ireland, Luxembourg and the Netherlands.

4) This may not be the last step:

The credit-rating agency put all [sic] 14 euro-zone nations — Austria, Belgium, Cyprus, Estonia, Finland, France, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia, and Spain — on "negative" outlook for a possible further downgrade.

Germany was the only country to emerge totally unscathed with its triple-A rating and a stable outlook.

A negative outlook indicates that S&P believes there is at least a one-in-three chance that a country's rating will be lowered in 2012 or 2013.

…

said it could also downgrade the euro zone's current bailout fund, the European Financial Stability Facility.

5) Here’s some qualitative comparisons:

The move puts highly indebted Italy on the same BBB+ level as Kazakhstan and pushes Portugal into junk status.

…

French Finance Minister Francois Baroin, speaking after an emergency meeting with President Nicolas Sarkozy, played down the impact of Europe's second biggest economy being downgraded to AA+ for the first time since 1975.

"This is not a catastrophe. It's an excellent rating. But it's not good news,"…

One would think that a ratings downgrade would affect borrowers rates. But, ratings are “old school”; going back to the period before instant global communication and widespread dissemination of raw data about borrowers. To the extent that lenders are doing their own due diligence, and just attaching a rating because it makes things look official, not much may happen.

It is not clear how far the downgrade will increase France's borrowing costs, since markets have already anticipated the prospect by raising the French risk premium over German Bunds.

"One notch is priced in but not more. The Franco-German spread can widen. It is about 130 basis points for the 10-year bond. …

Unfortunately, many funds that invest on behalf of others are required to divest when ratings agencies make problems “official”:

The downgrade could automatically require some investment funds to sell bonds of affected states, making those countries' borrowing costs rise still further.

"It's been priced in for several weeks, but the market had been lulled into complacency over the holidays …

The bottom line is that this news is quasi-official confirmation that Europe has not gotten its act together, and the situation has gotten harder instead of easier.